Achieving Diversity with Covered-Calls
The goal of the successful covered-call writer is to create a portfolio of positions that provides a good balance between profit potential and downside protection. One of the best ways to achieve this objective is through diversification, both in the choice of underlying equities and the selection of call options.
Choosing issues in a variety of industries, as well as different growth categories, can help you take advantage of a wider range of trading opportunities. In the current economic environment, many experts believe that small-cap firms offer the best growth opportunities because they generally have innovative products and services. At the same time, they may have higher share-price volatility and the associated liquidity risks because of their limited stature and relative instability. Those who endorse "value" investing would recommend owning under-priced stocks of established businesses that have a faster growth rate than large companies, but also more stability than small companies. A blue-chip portfolio would focus primarily on the stocks of large companies that, because of their asset base, tend to be the most stable. Another area of diversification includes the geographic component; buying stocks of companies located both in the United States and in other countries and regions around the globe. A favorable combination of these groups would blend expanding companies priced below their long-term valuation with strong potential for above-average earnings growth in the future.
Some investors believe that diverse portfolios should contain a few issues which will react differently to changes in economic conditions or the outlook for a specific sector or industry. These candidates are often identified as "hedge" positions and one way to illustrate the concept involves the oil sector. A conservative investor might hedge a portfolio by initiating positions in both an electric utility and a major oil service company. Higher fuel costs will have negative impact on the utility, but will boost the value of the oil service issue. Obviously, the reverse is also true; lower oil prices will impact the oil service company negatively while improving the utility's outlook. This strategy protect can help protect your portfolio against unexpected downturns in a particular industry and also enable you to take greater risks with a few positions, which may increase overall profits.
Stock owners with large positions in a specific issue can choose even greater diversification by spreading the sold calls over time as well as different strike prices. One can gain several benefits by writing a portion of the calls for a short period and the remaining calls further in the future. In the event of significant stock price activity, all of the various positions will not need to be adjusted at the same time. This may include having the stock called away or buying back some of the written calls and selling others. Another advantage is the level of option premiums may become more favorable than when the original series of calls were sold. At worst, only one group of options would be written when the premiums are low and hopefully, they would increase in value before the next expiration period. This type of diversification allows an investor to own various positions at different strike prices, smoothing the portfolio's balance as the market fluctuates cyclically. It also prevents all of one's stock from being committed at a single price, thus providing a favorable balance between potential return and downside protection.
Regardless of the manner in which you diversify your portfolio, it's important to understand that no strategy will prevent losses in every circumstance. In all cases, you should follow a precise and well-developed trading plan and be prepared to make timely, effective adjustments when unexpected events occur.